Policy Research Working Paper 8778 Low Tax Jurisdictions and Preferential Regimes Policy Gaps in Developing Economies Jonathan Leigh Pemberton Jan Loeprick Governance Global Practice March 2019 Policy Research Working Paper 8778 Abstract This paper reviews recent international initiatives and to ensure effective taxation of individuals, and (ii) an domestic policy developments aimed at helping countries anti-diversion rule tailored to reflect developing economy to protect their tax base against erosion by individuals and contexts and administrative constraints. These proposals companies that allocate assets to or route income via low tax include a possible definition of excess profits in low tax jurisdictions. The paper highlights the benefits and limita- jurisdictions and options for distribution keys to reallocate tions of existing policy instruments from the perspective of profits to countries where there is “real” economic substance capital-importing developing economies. Focusing on two and activity. The measures discussed could also address the common policy gaps for developing economies, options are diversion of profits to entities benefitting from preferential explored for (i) introducing necessary charging provisions regimes in countries with high nominal tax rates. This paper is a product of the Governance Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The authors may be contacted at jpemberton@worldbank.org. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team Low Tax Jurisdictions and Preferential Regimes: Policy Gaps in Developing Economies Jonathan Leigh Pemberton and Jan Loeprick JEL Classification Numbers: F23, H25, H26 Keywords: International Taxation, Low Tax Jurisdictions, Diverted Profits Tax Contents Contents ..................................................................................................................................... 2 1. Introduction ........................................................................................................................ 3 2. Attributing Income Received Offshore to Resident Individuals........................................ 7 3. Diverted Profits Provisions for Developing Economies .................................................... 9 Backing up transfer pricing rules ......................................................................................... 10 Controlled foreign company rules (CFC) - The problem with the focus on control ........... 11 The UK’s Diverted Profits Tax ............................................................................................ 13 Australia’s Diverted Profits Tax .......................................................................................... 14 A Diverted Profits Tax for Developing Economies? ........................................................... 15 An Anti-Diversion rule for Developing Economies? .......................................................... 17 Defining the target ........................................................................................................... 17 Defining diversion ........................................................................................................... 18 Scope ................................................................................................................................ 19 Risks to the investment climate: Double taxation................................................................ 20 Not my tax base? – DPR as a rebuttable presumption ......................................................... 21 Alternative mechanical rules................................................................................................ 22 4. Some Practical Considerations ........................................................................................ 23 5. Conclusion ....................................................................................................................... 25 Literature .................................................................................................................................. 26 Annex 1: A Draft Schedule of Taxation of Resident Individuals Who Are Controlling Persons in Relation to Certain Non-Resident Entities........................................................................... 29 Annex 2: A Draft Schedule for The Taxation of Diverted Profits ........................................... 32 Annex 3 An Illustrative Example ............................................................................................ 34 2 1. Introduction1 The lengths to which some large multinational corporations (MNEs) and wealthy individuals go to shelter their income from taxation has attracted increasing public attention. While international tax avoidance and evasion are not new phenomena, a combination of factors have given these issues greater prominence in public discourse. Perhaps the most important of these has been the financial crisis, which coincided with press stories about the ways in which some banks had facilitated tax evasion by their clients. 2 Public interest in the issue of international tax avoidance and evasion has been surprisingly sustained, given the technical complexities of the subject. In part this has been the result of further revelations about tax avoidance and evasion, including the so-called “Mossack Fonseca papers” and “Paradise papers” stories pursued by the International Consortium of Investigative Journalists. 3 Press coverage does not always make a clear distinction between tax evasion, which is illegal, and tax avoidance, which is not. Although the proposals in this paper address tax compliance issues arising from both tax avoidance and evasion, the distinction between the two is an important one. While MNEs will arrange their affairs to minimize their tax liabilities, increased scrutiny of their internal governance and “good corporate citizenship” mean that they will change their behavior in response to changes in the law. Nonetheless, for developing economies the underlying problem of tax avoidance is real enough. A growing body of evidence, comprehensively analyzed by Beer and others (2018) indicates that MNEs do indeed minimize their tax obligations, shifting profits from high to low-tax jurisdictions, which is estimated to result in a global net effect of reducing corporate tax revenue by 2.6 percent. UNCTAD (2015) estimates that 30% of global cross-border corporate investment stocks have been routed through off-shore hubs. The estimated annual tax revenue losses for developing countries amount to approximately $100 billion. The OECD (2015) estimates global CIT revenue losses between US$100 billion and US$240 billion annually at 2014 levels and Crevelli et al (2016) provide evidence that international tax base and rate spillovers are a relatively larger concern for developing countries. Individuals, in particular at the upper end of the wealth distribution, sometimes evade taxes by hiding income and assets offshore. Clearly individuals engaging in this kind of behavior do not respect the law and will only become more compliant if there is a realistic possibility of discovery and enforcement. Estimates of the amounts that have been transferred offshore have been based on a number of different sources. Drawing on anomalies in portfolio liabilities and assets reported globally, the amount of assets in offshore jurisdictions has been assessed at around 10% of global GDP (Zucman 2013; Pellegrini et al. 2016, Alstadsaeter et al. 2017). These estimates are supported by anecdotes on the use of offshore structures for tax evasion 1 The authors would like to thank Anne Brockmeyer, Colin Clavey, Jessie Coleman, Michael Durst, Chris Morgan, Marijn Verhoeven, and three anonymous reviewers from the IMF’s Fiscal Affairs Department for providing helpful comments. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and should not be attributed to the World Bank Group, its executive directors, or the countries which they represent. 2 Prominent among these was coverage of revelations by the whistleblower Bradley Birkenfeld about the Swiss Bank, UBS. UBS would eventually reach a deferred prosecution agreement with the United States’ Department of Justice. 3 See: https://www.icij.org/. 3 and money laundering by high net worth individuals (“Swiss/Liechtenstein leaks”, “Mossack Fonseca Papers”). International concern about potential weaknesses in the way international standards developed in the early part of the last century interact with modern ways of doing business is not new. 4 Similarly, governments in many countries had long-standing concerns about banking secrecy and the use of offshore financial centers for tax evasion. But the financial crisis gave these concerns new prominence and new urgency. The first sign of a renewed determination to tackle cross-border evasion and avoidance came in April 2009, when the G20 meeting in London declared that the “era of banking secrecy is over”. 5 This led to several countries withdrawing their reservations to the exchange of information on request article contained in model double taxation agreements. The Global Forum on Transparency and Exchange of Information (the Global Forum) was restructured to strengthen implementation of the international standard on exchange of information, through a process of peer review. Subsequently, the standard itself was enhanced to encompass automatic exchange of information about financial accounts. 6,7 That new standard was codified as the “Common reporting Standard” (CRS) and supported by a Model Competent Authority Agreement. 8 The introduction of the CRS is a major development. 9 It is notable that the CRS requires information to be exchanged that includes details of the beneficial owners of entities, including trusts, that might otherwise be used to disguise the true ownership of financial accounts. 10 This is enhancing the ability of governments in both developed and developing countries to detect funds that have been lodged in undisclosed offshore accounts for the purposes of tax evasion and other criminal reasons. 11 Some behavioral changes in individuals’ use of offshore jurisdictions can already be observed. De Simone et al. (2018), for instance, assess the effects of the Foreign Account Tax Compliance Act (FATCA), which increased reporting 4 For example, the OECD started consultations with businesses about the transfer pricing implications of business restructuring in 2005: http://www.oecd.org/tax/transfer-pricing/45690216.pdf, page 4. 5 The leaders’ declaration can be accessed here: https://www.g20.org/en/g20/timeline. 6 This development was modeled on legislation in the United States that was enacted in response to the revelations of tax evasion by US citizens involving secrecy jurisdictions. The Foreign Accounts Tax Compliance Act (FATCA) was signed into law in 2010 and came into effect in 2014. Alongside the legislation, the United States entered into agreements with other governments, based on two alternative models, which enabled the reporting process to take place by way of exchange of information between governments. See: https://www.irs.gov/businesses/corporations/fatca-governments. 7 G20 Finance Ministers and Central Bank Governors endorsed automatic exchange of information as part of an expected new standard in April 2013. http://en.g20russia.ru/events_financial_track/20130418/780961081.html. 8 http://www.oecd.org/ctp/exchange-of-tax-information/standard-for-automatic-exchange-of-financial-account- information-for-tax-matters-9789264216525-en.htm. 9 Automatic exchanges of information have already taken place between 45 jurisdictions. http://www.oecd.org/tax/OECD-Secretary-General-tax-report-G20-Finance-Ministers-Argentina-March- 2018.pdf. 10 The standard uses the term “controlling persons” but this is explicitly linked to the concept of beneficial ownership, as described in Recommendation 10 of the Financial Action Task Force Recommendations: http://www.fatf-gafi.org/publications/fatfrecommendations/documents/fatf-recommendations.html. 11 The Global Forum now has 154 members who are committed to the international standard on exchange of information. In 2018, 4,500 successful bilateral exchanges took place between 86 jurisdictions under the new AEOI Standard. There is an ongoing program of technical assistance to help all members to meet the AEOI standard. For more information see: http://www.oecd.org/tax/transparency/AEOI-Implementation-Report- 2018.pdf. 4 requirements for offshore accounts. 12 They find a significant response in the location of individuals’ investment assets and a decline of US$56.6 billion-US$78 billion in worldwide investment out of tax havens. Looking at policy initiatives in the US since 2009, including FATCA, Johannesen et al. (2017) report that around 60,000 individuals disclosed offshore accounts amounting to a value of around US$120 billion. But the long-term effect on the role and use of tax havens in the global economy is unclear. The stock of wealth held offshore since 2001 remains relatively constant (Alstadsaeter et al. 2018). 13 Alongside these efforts to tackle cross-border tax evasion, the international community has also been working to address the tax avoidance opportunities that have arisen as business practices have diverged from the assumptions underlying the international tax system. In response to a call from the G20 Finance Ministers, in 2013 the OECD published an action plan to address Base Erosion and Profit Shifting (BEPS) by multinational enterprises (MNEs). 14 At the heart of this action plan were steps to ensure that taxing rights are better aligned with the location of the underlying activity that gives rise to the profits of MNEs. There is some evidence of the effectiveness of the measures included in this BEPS initiative, in particular the role of anti-abuse measures in curbing observable profit shifting. Introducing effective transfer pricing (TP) regimes and related measures (thin capitalization), for instance, has been shown to reduce observable profit shifting (Beer and Loeprick 2015). However, these effects cannot be observed in all relevant areas of base erosion. 15 Importantly, when it comes to the allocation of significant returns to entities in low-tax jurisdictions, the BEPS guidance aims at clarifying the requirements for acceptable remuneration, in particular with respect to the risks actually borne by an entity. In essence, risks allocated contractually to entities need to correspond to the underlying functional profiles and the effective control of risks by those entities. Overall, the BEPS process adds complexity to tax policy and administration. Ongoing innovation and the introduction of additional and sometimes simple(r) anti-avoidance tools at the country level demonstrates that the BEPS measures are just an interim step in the continuing evolution of the international tax policy framework. This is especially true for developing economies that are more constrained by limited capacity in their tax administrations, 16 and is reinforced in ongoing discussions in the context of the OECD’s Inclusive Framework on BEPS. 17 Options for further reform can be distinguished into two broad categories. First there are proposals to introduce further anti-avoidance rules that are targeting specific risk areas and tend to be simpler to administer than an assessment of compliance with the Arm’s Length 12 FATCA requires foreign financial institutions to automatically submit client information to the US Internal Revenue Service (IRS). De Simone et al. (2018) also find evidence suggesting a post-FATCA switch in investment strategies to less regulated markets, namely real estate and art markets. 13 Looking at Tax Information Exchange Agreements, Menkhoff and Miethe (2017), also find a gradual decline in the effect of TIEAs on outbound income flows. 14 The immediate result of the BEPS project was the publication in 2015 of final reports covering all 15 actions. The focus has now switched to implementation of the BEPS recommendations, including the creation of a Multilateral Instrument that allows countries to upgrade their network of taxation treaties in a single process. See: https://www.oecd.org/ctp/BEPSActionPlan.pdf. As at 21 December 2018, 85 jurisdictions had signed the MLI. 15 At the same time, aggressive and poorly targeted enforcement efforts may also damage countries’ investment climates. Buettner et al. (2017) and De Mooij and Liu (2018) document, for instance, negative effects of introducing thin capitalization rules and transfer pricing on FDI. 16 This is one of the reasons for the creation of the Platform for Collaboration on Tax by the IMF, OECD, UN and WBG http://www.worldbank.org/en/programs/platform-for-tax-collaboration. 17 A recently published policy paper (OECD 2019) explicitly recognizes that current tax challenges include “risks remaining after BEPS for highly mobile income producing factors which still can be shifted to low-tax environments”. The draft also acknowledges that “any solution needs to be administrable by tax administrations and taxpayers alike and take account of the different levels of development and capacity of members”. 5 Principle. The BEPS discussion recognized the need to supplement enhanced transfer pricing regimes with more mechanical measures and recommendations, including a ceiling on interest deductions (BEPS Action 4). And, many countries are going further, the United States, for instance, recently introduced formulaic rules to capture intangible returns (Global Intangible Low-Taxed Income - GILTI). 18 Second are proposals aiming at more fundamental reform, including a possible shift towards more destination-based taxes or the introduction of regional or global formulary apportionment, with sales as the main allocation factor. 19 This paper falls into the first category with the objective of helping to address two gaps in the current international tax architecture that risk preventing effective taxation of individual and corporate profits that should be part of the tax base of developing economies. 20 The first gap arises because countries lack the policy tools to take full advantage of the progress made in respect of exchange of information. Many countries should already have or will soon have access to information that will enable them to detect and correct tax evasion involving offshore financial centers and undeclared assets. However, having the information is a necessary but not a sufficient step towards securing the tax revenue due on these undisclosed assets and income. Where ownership structures are straightforward, existing charging provisions in a country’s tax code may be sufficient. But it is commonplace for offshore holdings to be held via complex and opaque legal arrangements, designed to disguise the true ownership and side-step mainstream tax charges. Most developed economies have introduced legislation that addresses these situations, but this is often not (yet) the case in developing economies. 21 Section 2 of this paper explores this issue in more depth and suggests a possible solution. Secondly, an important gap persists with respect to aggressive corporate tax avoidance, which, while legal, is still a serious problem for developing economies seeking to grow their tax base as part of a program of domestic resource mobilization. Here the goal of the BEPS project is to ensure that taxing rights over profits are better aligned with the location of the underlying activity giving rise to those profits. This was a particular focus of Actions 8 to 10 of the initiative, which concerned transfer pricing. But there are limits to what can be achieved through transfer pricing. This was acknowledged in the BEPS discussion and Action 3 of the initiative considered how effective Controlled Foreign Company (CFC) regimes could provide additional safeguards. 22 It is not clear, however, that CFC rules are as effective as they once were. 23 Australia and the UK have recently decided that they need to address profit diversion more directly. It is even less clear how CFC rules are relevant to developing economies, which are mostly capital importing and have relatively few MNEs with domestic parents. Section 3 of this paper addresses this issue and proposes a policy response. 18 To target excess returns, a minimum tax of 10.5% is applied to foreign income exceeding 10 percent of tangible assets. As the excess is defined mathematically, it does not necessarily represent a return from intangibles. 19 See Auerbach, A. (2017): Demystifying the Destination Based Cash-Flow Tax. 20 The proposed mechanism for addressing ongoing base erosion by MNEs could also be considered in the context of more fundamental changes to the profit allocation rules that are contemplated in the Inclusive Framework’s recent Policy Note (OECD 2019). 21 Examples from Australia, France and the UK are discussed in section 2. 22 https://read.oecd-ilibrary.org/taxation/designing-effective-controlled-foreign-company-rules-action-3-2015- final-report_9789264241152-en#page17. 23 For example, unless all economies adopt CFC rules, they can easily be side-stepped by changing the domicile of the ultimate parent of an international group of economies. This issue is explored further in section 3. 6 Both sections 2 and 3 are aimed at contributing to a discussion on appropriate responses and tools. To illustrate how these ideas might be put into effect, draft model provisions are included as annexes to this paper. 2. Attributing Income Received Offshore to Resident Individuals Tax policies that address the risks posed by wealthy individuals who control significant assets at home and abroad but use offshore structures to manage their holdings and minimize their taxes matter for developing economies. 24 This typically involves multiple entities in a variety of offshore jurisdictions. Trusts are often used because they are very flexible, which is also one of the reasons why trusts are used for entirely legitimate purposes, such as the management of the affairs of individuals who lack the capacity to make decisions for themselves. The formal documentation of a trust does not always disclose the true purpose of the trust arrangement. In some cases, the trust deed may suggest that there is a charitable purpose by mentioning a well- known charity as one of the potential beneficiaries. In reality, the trustees in the offshore jurisdiction will often manage the trust’s assets in accordance with the instructions of the person who actually controls the trust. Using structures that include a mix of corporations and trusts established in different countries may make it harder to detect the true owner. It can also make it hard to establish a charge to tax if the tax legislation does not permit the tax authority to look through the structures and attach a liability to the true owner. So, the desired tax policy outcome is the ability to attribute to resident individuals income and capital gains accruing to entities they control but that are held through complex and opaque structures in offshore jurisdictions. In the absence of an effective income tax charge on these types of structures, there is a clear incentive to use them to legally avoid a domestic charge to tax. Introducing a charging provision will bring this income back within the tax base of the jurisdiction concerned. However, the use of these structures is not confined to legal tax avoidance. It is common for it to be associated with deliberate tax evasion and other criminal activity, including corruption. One of the ancillary benefits of an effective charging provision, coupled with increasing international exchange of information, is that it should help deter corruption, which often involves cash payments into offshore accounts. The link between tax evasion and other criminal activity including corruption is well established. 25 Having an effective charge to tax on income diverted into offshore structures is therefore a necessary part of the wider fight against corruption and other forms of criminality. It is the policy corollary to the improved access to information about such structures that is resulting from the Common Reporting Standard and increased international cooperation between tax administrations and between tax administrations and other arms of law enforcement. Anglo-Saxon jurisdictions (US, UK and Australia) have enacted specific rules, particularly targeting trusts. Typically, a charge may arise on the settlor (person putting wealth into the trust) and/or the beneficiaries. To be effective, charging provisions should not be limited to trusts but should apply generally to arrangements that may be exploited to exclude income from a charge to tax. So, for example, the UK has provisions known as the “settlements 24 The leaked data contained in the Mossack Fonseca and Paradise Papers illustrate the lengths some tax avoiders and evaders will go to disguise their ownership of assets and minimize their taxes. As discussed in Alstadsaeter et al. (2018) several developing economies that feature prominently among the countries that generated a lot of shell companies relative to the size of their economy also have high offshore wealth-to-GDP ratios. Similar observations apply to corrupt officials who commonly rely on corporate vehicles to conceal their identities. These include shell companies in offshore jurisdictions, trusts and foundations (WBG 2011). 25 For a recent discussion of the close relationship between tax crimes and corruption see OECD-WBG (2018). 7 legislation”, which apply to trusts but also to a wide range of other situations involving individuals, companies and partnerships. The overall purpose of the legislation is to tackle arrangements that are intended to divert income from one person to another who is either not liable to tax at all, or liable at a lower rate. To achieve this, the term settlement is defined widely so that a “settlement” includes any “disposition, trust, covenant, agreement, arrangement or transfer of assets”. 26 The legislation applies equally to domestic and offshore arrangements. However, the very breadth of the legislation, which dates back to the 1930s, does give rise to some difficulties of interpretation. Case law has established that to be caught a transaction has to involve an element of “bounty”. This requires a case by case examination of the arrangements in question and the application of the settlements legislation is technically demanding. 27 This type of approach to the taxation of offshore arrangements, based on a broadly defined scope that requires careful interpretation based on a case by case analysis, does not seem well-suited to the needs of developing countries. The UK has separate anti-avoidance legislation that targets transfers of assets abroad and that can impose a liability on the transferor, or the transferee, but these provisions are also complex and involve a motive test. 28 Countries that have a civil code tradition often have rules that address the use of entities that perform similar functions to trusts (foundations for example) but may not address trusts directly, because the concept is not recognized by the civil code. Whether or not trusts are recognized by domestic law, citizens of civil code countries can and do make use of them. Recognizing that fact, the French government introduced specific legislation in 2011 to bring trusts within the scope of its income, wealth and inheritance taxes and imposed new reporting obligations. Interestingly, the charge to income tax only arises when a trust makes a distribution. However, if excess income can be accumulated offshore tax free, that is a facility that can be taken advantage of. In 2015 Belgium introduced a regime that goes further, the so- called “Cayman Tax”. The regime takes a more direct approach by attributing the income of certain foreign legal structures to their Belgium resident founders. This looks to be a more effective approach, as it ensures that the Belgium resident is taxed as if the foreign structure did not exist. However, there were limits to the scope of the regime in its original form, as it only directly addressed the first tier of ownership. It seems possible to side-step the charge by having the first legal structure create a second, subordinate structure, which actually receives the income. Ideally, a charge to tax should be able to penetrate multiple layers of ownership in a complex offshore structure. Belgium amended its regime in late 2017 to address multiple layers of ownership. An effective charging provision needs to be clear in its purpose, which is to tax resident individuals on income and gains accruing to offshore structures they control. The charge to tax should not be contingent on there being a distribution of the income and gains to the ultimate owner, unless there is a good policy reason for that being the case, pension funds being an obvious example. Stating the purpose of the legislation very clearly reduces difficulties of interpretation that can make anti-avoidance provisions technically demanding to apply. The legislation also needs to be capable of dealing with the variety of structures and entities that are employed in offshore tax avoidance and evasion. The core issue is the definition of who is the “true owner” of the assets and income in question. 26 United Kingdom Income Tax (Trading and Other Income) Act 2005, Section 620. 27 For a recent discussion of the legislation and the concept of “bounty” see the decision in the case of Jones v. Garnett: https://publications.parliament.uk/pa/ld200607/ldjudgmt/jd070725/jones%20-1.htm. 28 The legislation is found in Part 13, Chapter 2 of Income Taxes Act 2007. 8 As part of the Common Reporting Standard, the OECD developed a definition of Controlling Persons that is designed to identify the ultimate beneficial owner of financial accounts for reporting purposes. As this is part of an international standard and supported by explanatory material that is intended to aid interpretation and implementation, this appears to be a good starting point for a model charging provision that could help countries realize their policy goals in this area. Annex 1 to this paper comprises draft model legislation that attempts to illustrate how this might be done. The draft provision is flexible in its scope, which can be narrowed or extended using the definition of what constitutes a low rate of taxation. Policy makers can also consider different definitions of what constitutes a controlling interest, although 25% is a commonly used threshold. 29 It is perfectly possible to have a lower threshold, or to apply the charge if a person is able directly, or indirectly to exercise ultimate effective control over any portion of the income of an offshore entity. 30 The provision makes explicit reference to trusts but also applies to arrangements not involving trusts. The proposal is targeted at passive income, so it will not discourage direct investment in real activity, which has been routed through an offshore center. The draft provisions also include a series of exclusions from the charge, designed to leave out of scope entities that are unlikely to give rise to a tax risk, such as pension funds and genuine charities. Whether or not the proposed approach in Annex 1 is the best means to impose a charge on offshore structures, there is no good policy reason not to have an effective charging provision of some sort. There are often practical obstacles to reform in jurisdictions where those individuals who are making use of offshore structures also exercise considerable political influence. Even more so, improving tax compliance by high net worth individuals is an important element for successful domestic resource mobilization in these countries. 3. Diverted Profits Provisions for Developing Economies This section briefly discusses why it is generally accepted that transfer pricing rules need to be supplemented by some form of additional defense against profit shifting, or diversion. This has tended to take the form of a controlled foreign company (CFC) regime. The second part of the section describes how CFC rules work and some of the shortcomings of an approach that focuses on control, particularly when viewed from the perspective of a developing economy that will generally be capital importing. The section then considers an alternative approach that has been adopted by Australia and the United Kingdom, in the form of a specific tax on diverted profits. This is followed by a discussion of how the thinking underlying these diverted profits taxes could be adapted to meet the needs of developing economies in a way that strikes a balance between the need to attract foreign investment and the need to have a rule that is relatively straightforward to apply. Recognizing that developing economies are a diverse group, the section concludes with a discussion of two alternative mechanisms for securing the corporate tax base by means of mechanical rules. 29 See for example the discussion of the concept of controlling persons in the commentary on Section VIII of the CRS. 30 For example, the United States has provisions that target income from investments made through foreign entities, defined as Passive Foreign Investment Companies, and these apply to any level of investment in such companies. 9 Backing up transfer pricing rules A central outcome of recent policy discussions on tackling cross-border tax avoidance is an update of transfer pricing guidelines issued by the OECD and the UN. The aim is to improve the correlation between taxation and value creation. At the same time, it is recognized that countries may need to complement those rules with additional defenses. That is because not all mechanisms for diverting profits to low tax territories are susceptible to challenge under transfer pricing rules. The most obvious example is the so-called “money-box” company. Simplifying somewhat, a money-box company is a subsidiary located in a tax haven that is funded by way of an injection of equity capital by its parent. That capital can then be invested to make a tax-free return, or typically be lent back to the parent on arm’s length terms. The pricing of the loan does not offend transfer pricing principles but clearly the overall result of the transaction is to strip profits from the home country into the tax-haven. The diagram below illustrates this simple example. The very simple money-box example described above could be challenged on various grounds but, in practice, aggressive tax planners will have inserted the funding arrangements into more complex business structures that are proof against substance over form provisions that might be used to attack a simple money-box. And finance is not the only mechanism that can be used to divert profits to a haven entity, without infringing transfer pricing rules. Some MNEs have been adept in structuring the ownership of intellectual property so that profits attributable to patents, brands and other intangibles are recognized in territories where they are subject to low or no taxation. Dischinger and Riedel (2011), for instance, find that intangible asset holdings are distorted towards low-tax subsidiaries in MNEs. Changes to the transfer pricing guidelines made as part of the BEPS project are intended to address this type of planning, but the issues of fact and law involved are complex. Consequently, many countries have developed separate legislation designed to counter the diversion of profits to tax haven subsidiaries. These are generally known as Controlled Foreign Company rules (CFC). It is questionable, however, whether CFC rules effectively address the profit-shifting risks faced by capital importing countries. Consequently, an alternative approach that is more commensurate with the administrative capacity in developing countries may be required. 10 Controlled foreign company rules (CFC) - The problem with the focus on control CFC rules have been around since the 1960s and have been adopted, in one form or another, by many countries. 31 Put very simply, CFC rules are designed to deter MNEs from accumulating profits in low-tax jurisdictions, particularly in the form of passive income. To do this they target the profits of foreign subsidiaries of parent companies that are subject to low rates of taxation, have not been paid up as taxable dividends to the parent and, generally, arise from passive investment, rather than substantive economic activity, such as manufacturing. However, like the rules for transfer pricing, CFC regimes have not necessarily kept pace with the way modern MNEs operate. The BEPS project recognized the case for having CFC rules, as a defense against profit shifting that complements transfer pricing: Transfer pricing rules, which generally rely on a facts and circumstances analysis and focus on payments between related parties, do not remove the need for CFC rules. CFC rules are generally more mechanical and more targeted than transfer pricing rules, and many CFC rules automatically attribute certain categories of income that is more likely to be geographically mobile and therefore easy to shift into a low-tax foreign jurisdiction, regardless of whether the income was earned from a related party. 32 Action 3 of the BEPS project makes recommendations that are designed to help countries that decide to implement CFC rules to ensure that they are effective in preventing the diversion of profits to lowly taxed foreign subsidiaries. The final report approaches this task by identifying the essential building blocks of an effective regime, the first of which is the definition of a CFC. As the name suggests, the concept of control is central to the CFC regime: it targets subsidiaries and other entities that are under the effective control of a parent entity that is a resident of the jurisdiction implementing the rules. The focus on control can be problematic, especially when viewed from the perspective of a developing country. It has been argued that the enactment of CFC regimes in developed economies would have a beneficial impact on tax planning that affects developing economies. 33 Simply put, if profits diverted from a developing country into a haven are caught by a CFC rule that applies to the parent, there is less incentive to strip the base of the developing country. The tax savings in the developing country will be offset, or even exceeded by the CFC charge on the parent. In reality, this is not likely to be the case for a number of reasons. Firstly, only some developed countries have CFC rules and several important jurisdictions do not have them and have no intention of introducing them -Action 3 makes recommendations but is not one of the four minimum standards that members of the Inclusive Framework are committed to. 34 Secondly, the CFC regimes in some countries are limited in scope and only target profits diverted from the parent jurisdiction, or are compromised in some way. 35 The EU did mandate the adoption of CFC rules in its 2016 Anti-Tax Avoidance Directive but the primary concern is the diversion of 31 Thirty of the countries that participated in the BEPS project operate CFC rules. The United States was the first country to adopt CFC rules. See also: Lehuede (2003) and Parada (2012). 32 OECD (2015 b), p. 14.. 33 See for example, Platform for Collaboration on Tax (2015), which recognized “For worldwide countries, CFC rules in principle provide some protection against tax avoidance through deferral”, p. 13. 34 For more information about the BEPS Inclusive Framework, see: http://www.oecd.org/tax/beps/beps- about.htm. 35 For a discussion of the United States system as it stood prior to the reforms passed by Congress in 2017, see the American Bar Association report on international tax reform: http://www.americanbar.org/content/dam/aba/migrated/tax/pubs/taskforceintltaxreform.authcheckdam.pdf. 11 profits from member states. 36 Thirdly, in the past, US and UK MNEs have used inversions (inserting a new top-co to be the ultimate parent of the group) to move to jurisdictions that do not have CFC rules at all, or have less rigorous regimes. 37 When we consider what developing economies can do themselves, adopting CFC rules domestically will be of limited benefit given that they are mainly recipients of inward investment by MNEs with foreign parents. 38 In a developing economy context, it may be more sensible to shift the focus of rules designed to complement transfer pricing from the concept of control to the essential mischief, which is profit diversion. However, doing so raises some fundamental questions about the design of an anti-diversion rule. CFC regimes were initially developed at a time when it was more usual to assert worldwide taxing rights over the income of corporate citizens and anything that attempted to avoid this was a legitimate target of the CFC regime. The CFC rules introduced in the UK in the 1980s illustrate this quite well. They included various defenses against a CFC charge, such as an exemption for CFCs carrying on certain types of activity and a motive test. But the motive test was characterized by critics as including a default assumption that if activities are diverted into a low tax jurisdiction, they could have been moved to the UK and the profits arising should be taxed accordingly. 39 More recently developed countries have tended to adopt a more territorial approach to the scope of their CIT systems and the UK is an example of that. 40 It makes even less sense for an anti-diversion rule that is designed with capital importing countries in mind to be designed to tax all profits diverted to a low tax jurisdiction by an MNE; that would constitute a significant overreach. So, an anti-diversion rule needs to define what constitutes diversion anew and provide a mechanism for calculating the amount of profit that has been diverted from the country itself and how it should be taxed. Australia and the UK have done just that and introduced a Diverted Profits Tax. 41 Unsurprisingly the two regimes 36 “In particular, in order to ensure that CFC rules are a proportionate response to BEPS concerns, it is critical that Member States that limit their CFC rules to income which has been artificially diverted to the subsidiary precisely target situations where most of the decision-making functions which generated diverted income at the level of the controlled subsidiary are carried out in the Member State of the taxpayer.” https://eur- lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016L1164&from=EN. 37 Even without tax driven inversions, market forces will tend to encourage the ownership of MNEs in jurisdictions without effective CFC regimes. The lower effective tax rate on foreign profits was cited as one of the reasons Kraft was able to take over Cadburys, for example. 38 As noted by UNCTAD (2015), a CFC regime “may only be relevant for developing countries that have sufficient outward investments to warrant introducing and administering such legislation”. Just 8 of the top 100 global MNEs were domiciled in developing economies in 2017 (UNCTAD 2018). 39 This was achieved by asking if, had the CFC and any related entities not existed, it was reasonable to suppose the profits would have accrued to a UK taxable person (Paragraph 19(1), Schedule 25, Income and Corporation Taxes Act 1988). 40 This was an explicit policy goal of the UK’s recent changes to its CFC regime and the de facto result of the “check-the-box” system and associated rule changes in the USA (see the consultation document issued by the UK Government in 2011, explaining the direction of its CFC reforms: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/81286/corporate_tax_reform_par t2a_cfc_reform.pdf). 41 France also included a Diverted Profits Tax in its 2017 Finance Bill but the Constitutional Council ruled that it was unconstitutional. The tax would only have been applied during an audit. The Council ruled that the law was not specific enough about how the tax would be calculated and the link to an audit meant that the tax would only be applied at the discretion of the tax administration. See: Décision n° 2016-744 DC du 29 décembre 2016, available online: http://www.conseil-constitutionnel.fr/conseil-constitutionnel/francais/les-decisions/acces-par- date/decisions-depuis-1959/2016/2016-744-dc/decision-n-2016-744-dc-du-29-decembre-2016.148423.html. The diverted profit tax was also discussed in New Zealand, see: http://taxpolicy.ird.govt.nz/publications/2017-dd- 12 have several features in common and illustrate some of the main design questions that the framers of an anti-diversion rule need to address. Both have two legs: a rule targeted at schemes designed to avoid the creation of a taxable permanent establishment (PE) and a charge on profits diverted by means of arrangements, or entities, lacking economic substance. The first issue was the subject of BEPS Action 7, 42 so it is the second element that potentially breaks new ground. What follows is a high-level description of this aspect of the two Diverted Profits Taxes and a discussion of how the concept might be adapted to meet the needs of developing economies. The UK’s Diverted Profits Tax The United Kingdom’s Diverted Profits Tax (DPT) took effect on 1 April 2015. It is primarily designed to act as a deterrent: “The requirement to pay the tax “up front” provides a strong incentive for groups to provide timely information about high-risk transactions and how they fit into the groups global operations. It reduces the information bias inherent in complex cases and promotes full disclosure and constructive early engagement with HMRC.” 43 This deterrent purpose has affected the design of the tax in a number of ways. It is deliberately designed to be penal in its effect. It is a separate tax from mainstream corporation tax, is charged at a higher rate and in HMRC’s view does not fall within the scope of the UK’s double taxation agreements. The tax must be paid immediately on the basis of an initial “best of judgement” assessment by HMRC. HMRC’s guidance on the operation of the DPT runs to over 100 pages, but the basic workings of the tax can be described more shortly. It applies to UK resident companies and foreign companies with a UK PE or an avoided PE 44 that are using contrived arrangements with connected persons to reduce UK tax. It targets “material provisions” imposed or agreed between the UK company/PE and the connected person. The term is defined broadly to include any arrangements, understandings or practices affected by means of a transaction or series of transactions. As HMRC’s guidance makes clear, the tax is targeted at “arrangements involving entities or transactions lacking economic substance”. 45 Deciding whether an arrangement is transfer-pricing-pe/chapter-2. But it was not implemented. According to a Cabinet Paper released by Inland Revenue “Introducing a DPT would mean that there would be a new type of tax, separate to income tax, to deal with a minority of aggressive multinationals. It could impact on foreign investor’s perceptions of the predictability and fairness of New Zealand’s tax system for foreign investment. As a separate tax from our general income tax it may produce unintended adverse consequences for taxpayers – especially with regard to normal grouping of tax attributes (for example income tax losses would not be able to be set off against diverted profits). A DPT may also have an unintentional negative impact on compliant taxpayers. The more we get into imposing arbitrary taxes the greater the risk of other countries doing the same to our exporters. Overall a DPT chips away at the consistency, neutrality and relative simplicity of our tax system from a global perspective.” See more: http://taxpolicy.ird.govt.nz/sites/default/files/2016-other-cabinet-paper-transfer-pricing.pdf. 42 See: OECD (2015c). 43 See : https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/480318/Diverted_Profits_Tax.pd f, p. 4. 44 According to HMRC’s DPT guidance an avoided PE arises where a person carries on activity in the UK in connection with the supply of goods, services or other property by a foreign company and that activity is designed to ensure that the foreign company does not create a PE in the UK, and either the main purpose or one of the main purposes of the arrangements put in place is to avoid UK tax, or there are arrangements designed to secure a tax mismatch, such that the total tax derived from UK activities is significantly reduced. 45 Ibid, p. 9. 13 caught and, if it is, how much tax is due is potentially a complex task. This is another incentive for taxpayers seeking certainty to make an early disclosure of arrangements they think might be subject to the tax. To trigger the tax, the material provision must result in “an effective tax mismatch outcome”. This is defined as a reduction in the UK taxpayer’s liability by an amount that exceeds the consequent increase in the connected party’s tax liability, although in practice this is not as straightforward as it sounds. There are some exemptions, for charities for example. There is also a let out if the increase in the connected party’s liability is 80% or more of the value of the reduction in the UK liability. In addition to generating an effective tax mismatch outcome, to be caught, the material provision must lack sufficient economic substance and be designed to reduce tax. The starting point for applying the insufficient economic substance test is “whether it is reasonable to assume that the transaction(s) or the involvement of a person in the transaction(s) was or were designed to secure the tax reduction (as defined through the effective tax mismatch outcome rule)”. 46 However, provisions will not be caught if the expected non-tax financial benefit was greater than the financial benefit of the tax reduction. If all the conditions for applying the DPT are met, the tax is calculated in one of two ways. If the transactions would have taken place but are not correctly priced, the tax is calculated by reference to the correct transfer price. The taxpayer has the option to correct the transfer pricing in their corporate tax return within a fixed period, and so avoid the imposition of the DPT. However, if the transactions would not have taken place, or would not have been executed in the way that they were, had tax not been a consideration, the tax may be calculated by reference to a re-characterized transaction(s) termed as the ‘relevant alternative provision’ in the guidance: “the alternative provision that it is just and reasonable to assume would have been made or imposed (…) had tax on income not been a relevant consideration for any person at any time”. 47 Finally, DPT does not apply to small and medium enterprises. 48 Australia’s Diverted Profits Tax Australia’s provision that resembles the first leg of the UK’s DPT, which is targeted at arrangements to avoid the creation of a taxable PE, took effect on 1 January 2016. The basic design of the second leg was the subject of consultation in 2016 49 and enacted in April 2017. The design is based on the UK model and has a similar rationale (encouraging greater openness and addressing information asymmetries), 50 but there are differences in the version that has been legislated: it includes finance transactions, which are excluded from the UK DPT, and the economic substance test is based on a functional analysis. The tax applies from 1 July 2017 46 Ibid, p. 30. 47 Ibid, page 13. 48 The legislation relies on the definition of small and medium enterprises provided in the Annex to Commission Recommendation 2003/361/EC of 6 May 2003 (concerning the definition of micro, small and medium-sized businesses). 49 See: Howe and Khomenko (2017) and the Australian Treasury: http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2016/Implementing-a-diverted-profits-tax. 50 See: https://www.ato.gov.au/General/New-legislation/In-detail/Direct-taxes/Income-tax-for- businesses/Diverted-profits-tax/?page=1#Legislation_and_supporting_material. 14 and is focused on significant global entities (defined as having global income of more than A$1 billion). The principal feature of the Australian DPT is that it applies where it is reasonable to conclude that a principal purpose of the arrangement is to secure a tax benefit. In addition, it needs to be reasonable to conclude that the scheme at stake does not pass the sufficient foreign tax test and does not pass the sufficient economic substance test. So, as in the UK, the Australian DPT applies if the transaction in question gives rise to an effective tax mismatch and has insufficient economic substance. The sufficient foreign tax test is a let out for cases where the increase in the connected party’s liability is 80% or more of the value of the reduction in Australian tax payable. The economic substance of entities involved in the arrangement is to be assessed by reference to the functions they undertake, transfer pricing principles and “any other relevant matters”. Finally, there is a de-minimis rule, so that the tax does not apply if the aggregate income of the taxpayer in Australia, including any DPT tax benefit, is A$25 million, or less. If the Australian DPT applies, the Australian Tax Office (ATO) issues an assessment (the tax does not operate on a self-assessment basis). The ATO may impose a penal tax rate of 40 percent on profits transferred offshore through related party transactions with insufficient economic substance. The Australian DPT also provides the ATO with more options to reconstruct the alternative arrangement on which to assess the diverted profits where a related party transaction is assessed to be artificial or contrived. It requires upfront payment of any DPT liability, which can only be adjusted following a successful appeal against the assessment, which cannot be lodged until 12 months after the assessment. It puts the onus on taxpayers to provide relevant and timely information on offshore related party transactions to the ATO to prove why the DPT should not apply. Table 1. Main features of the two DPTs Feature UK Australia Rate (higher than CIT) 25% 40% Tax payable up front √ √ Threshold/de minimis SMEs out and 80% rule for Targets MNEs with income tax mismatch >A$1bn and let out if Aus income